Volatility, Intermediaries and Exchange Rates
45 Pages Posted: 20 Nov 2016 Last revised: 4 Oct 2018
Date Written: September 6, 2018
This paper studies how time-varying volatility drives exchange rates through financial intermediaries’ risk management. We propose a model where currency market participants are levered intermediaries subject to value-at-risk constraints. Higher volatility translates into tighter financial constraints. Therefore, intermediaries require higher returns to hold foreign assets, and the foreign currency is expected to appreciate. Estimated by the simulated method of moments, our model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, the exchange rate volatility puzzle, and generate deviations from covered interest rate parity. Our empirical tests verify model implications that volatility and financial constraint tightness predict exchange rates.
Keywords: Volatility, Financial Intermediaries, Exchange Rates, Currency Risk Premium, Value-at-Risk
JEL Classification: G15, G20, F31
Suggested Citation: Suggested Citation